The first half of 2022 has been fraught with inflation, supply chain issues, higher rates and a war between Russia and Ukraine. All these factors have led to market volatility and all major assets classes being down substantially year to date. Although no one likes to see investments decline, the market environment may be providing a unique opportunity for long-term investors. One technique to consider is a Roth conversion.
Let us begin with a quick reminder about the difference between a Traditional IRA and a Roth IRA. In a Traditional IRA, you receive a current year tax deduction on the contribution, it grows tax deferred, and income taxes are not owed until you begin taking distributions. As distributions are taken, ordinary income taxes are owed on both the contributions and the earnings of the Traditional IRA. With a Roth IRA, you do not receive a tax deduction on the contribution, but the earnings and growth within the Roth IRA are tax free. Unlike the Traditional IRA, all distributions from Roth IRAs are tax-free as well. The tax-free growth and distributions can be appealing for investors, but many are limited in their ability to contribute to a Roth IRA due to IRS imposed income limits. A married couple, earning over $204,000 in Modified AGI in 2022 would not be eligible to make a Roth contribution1. So how do they get the benefits of tax-free growth?
A Roth conversion is another avenue to move money into the tax-free Roth IRA. A conversion allows you to take a portion (or all) of your pre-tax IRA and convert the dollars to a Roth IRA. When doing the conversion, you recognize the amount of the distribution as taxable income in the year of conversion. Basically, the IRS is happy to let you move to the Roth IRA as long as you pay the tax to do so.
With the markets trading down significantly in 2022, it might be a good time for some investors to execute a Roth conversion. For example, assume an IRA was worth $150,000 at end of year 2021. Further assume that the current value is down -20% due to market movement and is now valued at $120,000. Assuming a 40% combined Federal and State tax rate, the income tax owed on conversion today would be $48,000 whereas the tax would have been $60,000 prior to the market downturn. For an investor that can afford to pay the taxes from another source, and who believes that markets will recover, paying less tax to move the funds to a tax-free vehicle might make sense.
While the opportunity to pay reduced taxes is attractive, there is more to consider before embarking on a Roth conversion strategy.
• To benefit from a post-conversion market recovery in the Roth IRA, the taxes need to be paid from an outside source. Be sure other funds are available to pay the income taxes before converting any IRA dollars to Roth.
• Be aware of your current income tax rate versus the likely future rate when IRA dollars would otherwise be withdrawn. For those still earning high incomes, or with large taxable events like a real estate sale, the higher current rate might outweigh the potential discount of a lower market value on conversion.
• Note your future Required Minimum Distributions. The IRS requires IRA owners to take Required Minimum Distributions at age 72 based on their actuarial life expectancy. They start at 3.66% of the IRA balances and increase annually over your lifetime2. If you have substantial IRA balances, your RMDs may push you into a higher tax bracket in the future and thus a Roth conversion might be prudent today. If, however, your IRA balances are not a large portion of your estate, the RMD might be nominal and paying future taxes is not of great concern.
• Consider your charitable intentions. After age 70 ½, IRA holders are allowed to donate distributions from their IRA directly to charity via a Qualified Charitable Distribution without it impacting their taxable income. Some investors do not need their qualified withdrawals and are taking advantage of the QCD (allowed up to $100,000 annually). If this is something you would consider, there is no need to pay tax on a Roth conversion today.
As you can see, there is a lot to consider before converting IRA dollars to a Roth IRA and paying the taxes. If you are interested in moving pre-tax dollars to a tax-free vehicle while the markets are depressed, reach out to your financial professional and review your entire situation. For some, this could be the lemonade you make out of a lemon of a market.
For a Roth IRA, earnings withdrawn prior to reaching age 59½ and/or not meeting the five-year holding period may be subject to a 10 percent penalty in addition to income tax. After-tax contribution amounts are generally returned income tax free; however, for Roth conversions, if converted amounts are not held for the five-year period, distributions may be subject to a 10 percent penalty.
This information is a general discussion of the relevant federal tax laws. It is not intended for, nor can it be used by any taxpayer for the purpose of avoiding federal tax penalties. This information is provided to support the promotion or marketing of ideas that may benefit a taxpayer. Taxpayers should seek the advice of their own tax and legal advisors regarding any tax and legal issues applicable to their specific circumstances.
1 Married Filing Jointly Roth IRA Phaseouts occur between $204,000 and $214,000; Single Filers phase out between $129,000-$144,000 of Modified Adjusted Gross Income.
2 Based on Uniform Life expectancy of 27.4 years at age 72 per IRS tables